(PUB) Investing 2016

Third Avenue Management shuttered its Third Avenue

Focused Credit fund in early December

2015

That fund was atypical in that it employed a high-risk

strategy focused on distressed debt, but the story

definitely spooked the market. Losses across the broad-

er high-yield bond Morningstar Category, however,

were not severe. The average fund in the category fell

during December. That said, it was still a

rough year overall for the junk market, with the most

pain coming from energy and commodity-related

sectors, which have been hit hard by a slide in oil and

an economic slowdown in China. The average loss

for the category was

for the year, while some

funds suffered much more.

How likely is it that other high-yield funds will

follow in Third Avenue Focused Credit’s footsteps?

Not likely. Most high-yield funds have far less risky

portfolios thanThird Avenue Focused Credit. That fund’s

large cadre of distressed names made it one of the

riskiest high-yield funds around. The portfolio held a

big allocation to the lowest-quality tiers of the junk

market and a sizable stake in issues without ratings,

and it was concentrated. As of July

2015

, close to

half of the fund was in bonds rated below B and

another

40%

in nonrated fare. By contrast, the median

allocation to below-B rated debt in the high-yield cate-

gory is just

12%

, and most funds hold little non-

rated debt. (Firms often classify equities as nonrated,

explaining the large nonrated stake reported by

funds such as Silver-rated

Fidelity Capital & Income

FAGIX

.) The Third Avenue fund was also unusually

concentrated, with a

position in its largest name,

the troubled

Clear Channel Communications

(now

iHeartMedia

IHRT

), and only around

positions over-

all. Most high-yield funds are more diversified and

focus on less risky credits.

What are the signs of outsized credit or

liquidity risk?

There are several telltale signs, such as large stakes

in the lowest-quality bonds, especially if they’re concen-

trated in individual names or sectors. Nonrated

bonds make up only a tiny part of the market, while

bonds rated

CCC

or below account for

13%

of the

Bank of America Merrill

High Yield Master

Index.

Those issues can be difficult to sell in stressed mar-

kets and are more susceptible to permanent capital

losses. Another sign of risk is a yield that well

exceeds market norms, as it can denote outsized credit

or liquidity risk. Finally, shareholder concentration

or volatile flows can leave a fund vulnerable to a large

redemption request at a highly inopportune time,

raising the risk that a manager will have to sell quickly,

driving down prices in the process.

What should a high-yield investor do?

It is important to take a long-term perspective when

investing in junk bonds. Given the sector’s higher

correlation to stocks, investors should view high-yield

bonds as long-term tools for income generation

but not as safe-haven assets. For those uncomfortable

with the sector’s risk profile, it is probably best to

steer clear. Morningstar’s Christine Benz points out

that many institutional asset-allocation experts

skip high-yield bonds altogether and argue they don’t

add anything to a portfolio that one can’t get from

standard stock and bond allocations.

For those who do invest in high yield, what are the

key considerations?

Look for well-resourced managers with proven track

records who don’t reach for yield. When Morningstar

analysts evaluate high-yield funds, we favor

managers who have demonstrated bond-picking skills

through a variety of different market environ-

ments. Because success in high yield is driven in large

part by security selection and avoiding permanent

capital losses following defaults, the size and experi-

ence of a firm’s analyst staff is also important.

Contact Sarah Bush at

sarah.bush@morningstar.com

High Yield Faces Challenges but Isn’t in

Third Avenue’s Shoes

Income Strategist

Sarah Bush